An operator's guide to financing their small business acquisition

For operators looking to acquire a small-to-medium-sized business (SMB), understanding how you’ll pay for the acquisition isn’t just about knowing where the money comes from—it's about picking an appropriate financing structure for your business and goals. That's why lenders, particularly in Small Business Administration (SBA) deals, require personal guarantees from operators. Your commitment to the deal's success must match the risk you take.

Options for financing your small business acquisition

Most SMB acquisitions involve three key financing sources: bank debt, investor equity, and seller participation. Understanding how each works—and how they work together—is essential for any deal’s success.

Debt options

The most common debt source in lower-middle market deals (SMBs) is the SBA 7(a) loan program. These loans offer terms, including 10-year repayment periods versus the typical 5 years for commercial loans.

While the 7(a) loan program typically caps loans at $5M, some banks will also do what's called a pari passu loan—Latin for 'equal footing'—which can extend beyond the standard $5 million SBA limit.

For deals larger than $5 million, operators typically turn to either commercial loans or Small Business Investment Company (SBIC) funds. These professional institutions often offer different terms and may have additional requirements beyond SBA loans.

While higher interest rates have impacted the debt market, deal activity remains strong. What we’ve seen in practice, is that buyers usually consider the loan terms more than the rates. With SBA's 10-year repayment period versus 5 years for commercial loans, the payments are more spread out, even at the higher rates.

Investor equity

Investors in SMB deals typically focus on two key elements: Preferred returns and profit participation. Most deals in this segment of the market include a preferred return of 10 to 15 percent, which means investors receive this return on their capital before other distributions occur. Using this preferred return structure, investors can potentially mitigate some of their investment risk, while still having exposure to the economic upside of the deal.

Generally, investors are most interested in the economic upside of the deal, which is where the majority of their returns will come from if an investment is successful, rather than the stated preferred return.  

This risk level also impacts governance structures. Investors typically seek board representation and information rights to monitor their investments. The specific terms vary by deal size and investor involvement, but most structures aim to give investors oversight while leaving operators with day-to-day control.

Seller participation

Sellers can participate in deals through either seller notes (e.g., providing debt) or equity rolls (e.g., continuing to own a piece of the business). Recently, SBA rules have evolved to allow more flexibility with seller equity rolls, though this wasn't always the case.

Seller notes are a heavily negotiated item—some sellers are willing to take a longer-term or lower interest rate. There are also unique implications at hand when structuring the seller’s note. For example, if you can get a seller to do a full standby note for 2 years on an SBA deal, that's an advantage because it can count toward your down payment.

A seller's choice between notes and equity often depends on their outlook and timeline. Those who do not need the cash for retirement typically prefer notes for reliable income and tax savings, while younger sellers might be open to equity rolls if they believe the business has significant growth potential under new ownership and want to have continued involvement.

The SBA typically favors seller notes, preferring 5 to 20% of the deal to be financed through seller participation. However, certain structures remain off-limits, like performance-based earnouts, which can't be part of SBA-backed deals.

It’s important to note that seller financing is a form of leverage, while an equity roll is not. With seller financing, you still need to make good on repaying the amount lent, and this will come out of your free cash flow. With an equity roll, the seller is sharing the same equity risk as you – equity holders will only get distributions if the business is performing well.

Alignment of interests

The amount of "skin in the game" from each party significantly impacts deal dynamics. For operators, investors typically want to see meaningful personal investment—often 20 to 50 percent of their liquid assets.

When operators sign for an SBA loan, they’re personally guaranteeing the loan against their assets. Investors tend to look more favorably towards this type of commitment from an operator because their incentive to succeed is very high.

This alignment extends beyond just financial commitment. The combination of personal guarantees, investor-preferred returns, and seller participation creates a structure where all parties share risks and rewards. When structured properly, each stakeholder has clear incentives to support the business's long-term success.

Making your financing sources work

Choosing the right financing isn't just about securing funding—it's about creating a structure that serves all stakeholders while maximizing your odds of success. Whether you're using SBA debt, bringing in outside investors, or negotiating seller participation, each element requires careful consideration.

Ultimately, these transactions are a negotiation and a balance. While the seller is trying to optimize what they get for their business, you're focused on having enough resources to make the business successful moving forward. 

Understanding how these pieces fit together—and how to align incentives across your financing sources—can mean the difference between a deal that thrives and one that struggles to take off. The most successful operators will make sure to understand these dynamics before they sit down at the table with a seller.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.